Why Did We Put Ratings Agencies' Ratings Into The Law?

from the good-questions... dept

Problems and potential conflicts coming from the bond ratings agencies were well-known well before our financial crisis hit, but still many are pointing the blame finger at those ratings agencies. And, it's certainly tempting to do so. Just as with the famed financial analysts during the late 90s tech boom, the credit agencies appear to have rated certain debt offerings very highly, despite recognizing how intrinsically risky the investments were. Given what happened following the dot com bubble collapse, it's quite likely that the bond rating agencies Moody's and S&P will get slapped down for their "mistakes."

But that would be a mistake. Both Moody's and S&P were merely expressing an opinion on the credit-worthiness and risk of the various debt offerings. An opinion should never be considered illegal by itself. The problem was that people started relying on these opinions as if they were factual realities. And who's to blame for that?

Well, in part, it's the government -- which wrote the rating agencies' ratings into law, requiring certain regulated institutions to maintain a certain percentage of "highly rated" bonds in order to engage in certain activities. That made it so the real focus was on the opinions of Moody's and the S&P, rather than on what investors believed the actual risk was on those bonds. As the link here notes, why not let the market decide what the actual risk is on these bonds, rather than trusting the (somewhat questionable) opinions of individuals who are biased and conflicted?

Opinion vs Advice?

IANAL, but I would imagine that as the ratings agencies' ratings were written into law, and the ratings agencies receive money to provide the ratings and they publish the ratings, I'd suggest that the ratings would be construed as advice, not as opinion.

Re: Re: Opinion vs Advice?

I can't speak for the US, but here in Australia there is a definite legal difference between offering an opinion and offering advice.

A licensed financial adviser provides advice, which if shown to be negligently provided could be cause for legal action.

However if you had a conversation with your mate at the pub, he'd be providing an opinion, which would have no legal basis.

You pay a medical doctor for medical advice, you ask a mate for their medical opinion. You can sue the provider of advice when that advice is offered in a professional capacity, but not of opinion.

Common English usage often blurs the precise meaning of words. Advice and opinion might be used interchangeably while having a general discussion, but they do have subtly different meanings, especially once we start entering the legal realm.

thin data makes for poor models

This may be a vast oversimplification, but here goes:

On average credit default events are rare and sudden: parties typically become less credit-worthy a little at a time, but the markets find this out all at once: data that is confidential one day is public the next, so markets tend to do a lousy job of estimating creditworthiness.

Credit rating agencies were supposed to mitigate this somewhat by introducing tiers into which commercial paper fell. This did two things, in principle: it separated risky companies from less-risky companies, and it multiplied data: highly-rated companies rarely suddenly defaulted without being downgraded first.

But this doesn't really solve the underlying problem: companies' balance sheets improve or decay a day at a time, but the market (and the credit rating companies) still find out all at once.

So in this vastly simplified analysis you can take your pick: you can either have unreliable credit ratings or you can have unregulated flow of balance sheet information and subsequent insider trading.

Re: thin data makes for poor models

The point is not that we shouldn't have credit agencies; they serve a purpose and are free to do as they like, being private entities. However, the problem lies with government mandating that their ratings be considered factual and unquestioned. Since institutions are not even allowed to act without a properly "safe" portfolio of bonds as determined by the rating agencies, there is no longer the incentive to check their opinions--what could have been avoided in a free market by those responsible enough to rate the risks properly is ensured by the government's typically boneheaded law in the name of "regulation".

Disagree

Gonna disagree with you, Mike. The ratings agencies do need to be held (at least partially) responsible. Here's why. Despite being a private company, the ratings agencies are heavily regulated, as is the entire financial sector. Most people know that a broker needs to pass the Series 7 tests - but most don't know what they are. They are in fact, government (via the SEC) certifications. There are similar tests for financial planners, compliance officers, etc. You can't take these tests as an individual - you have to be sponsored by a company. Those companies are assuring the government that the people performing those jobs are being honest and are properly supervised with adequate oversight. And thus the companies are assuming the risk that if they screw up, they will be fined. The companies take that risk in order to make money - that is their business model!

The government should be held partially responsible, since I think it was a lack of regulation (again the SEC) that allowed the companies to get away with this for so long. But just because there isn't a cop watching, doesn't mean that running that red light is legal - or safe - or you shouldn't get in trouble if you cause an accident by doing it.

There is enough blame to go around and the ratings agencies should get their fair share.

Fraud?

Isn't part of this whole thing that in many ways the ratings companies essentially engaged in fraud of a broad definition? as an example imagine I started a ratings company and instead of looking at anything of value I used the color of the sky that day to say if a company was credit worthy--but didn't tell anyone that but said my analysis was based on real financial practices....wouldn't that be fraud in many ways to anyone that followed my advice (since I was fraudulently stating I was using one thing to do the job but really not). In many ways these companies said they were really investigating the companies and determining their worthiness, when it turns out they really weren't and just mouthing that they were all perfectly fine.

the law and the profits

The ratings firms were mandated in the wake of the junk bonds problem in the late Eighties and early Nineties.

The subprime mortgage problem began with the bad loans and exploded after ratings firms rated the bond packages of these bad loans as AAA. It seems that these ratings firms were giving these ratings either as a favor to the bond sellers or because the firms had been spun off by the bond sellers.

The problem seems to be that the laws were poorly written, such that what the ratings firms did was not completely illegal, and/or the prosecution of the laws is difficult. And expensive.

In general, the financial sector seems to get a free pass when it comes to law enforcement. The perception is that revenue and profits trump the rule of law.